Bull Market in Metals Is Just Beginning
By Jim Jubak
MSN Money Markets Editor
09/24/2003 07:10 AM EDT
URL: thestreet.com
Which is the better buy now, technology or mining stocks?
Surprise -- the winner is mining stocks.
They have more momentum: Dull ol' mining stocks such as Inco (N:NYSE) are up 44% in the last six months vs. 36% for the technology-laden Nasdaq Composite Index.
Mining stocks have more upside potential: Cyclical metal stocks are just about six months into a two- to three-year bull market cycle based on accelerating economic growth, while the technology sector has largely discounted its recovery until well into 2005.
And mining stocks are less risky: Even a mining stock like Freeport-McMoRan Copper and Gold (FCX:NYSE) , which is up 98% in the last six months, still trades at just 19 times projected 2004 earnings, well below the 23 to 24 times earnings the stock sees at cyclical peaks. It's also certainly not nearly as risky as PMC-Sierra's (PMCS:Nasdaq) price-to-earnings ratio of 174 based on 2004 projections after its 111% run-up in the last six months.
Yet I'll bet that the average investor's portfolio is heavy on technology stocks, especially after the Nasdaq's rally this year, and light on mining stocks. Jubak's Picks, for example, holds one energy stock, ExxonMobil (XOM:NYSE) , but not a single mining stock.
Time for a Change
Well, let's fix that. Here are three mining stocks, Inco, Freeport-McMoRan and Southern Peru Copper (PCU:NYSE ADR) , for you to research for your own portfolios. I'm adding Inco and Freeport-McMoRan to Jubak's Picks with this column.
I'm starting with Inco because the story for mining stocks is especially easy to understand at this huge nickel producer. According to Merrill Lynch, all major excess nickel stockpiles had disappeared around the globe by mid-September. Norilsk of Russia, the world's largest nickel producer, had sold its 60,000 metric tons of uncommitted inventory. The last big inventory without a buyer is the 36,000 metric tons available for sale on the London Metal Exchange. At the current rate of global drawdown, that's about an 11-day supply. The nickel market is suddenly tight.
That's led to a roughly 40% increase in nickel prices this year to a recent high of $4.50 a pound. In the last bull market for nickel from 1988 to 1991, the price averaged almost $5 a pound and went above $6 a pound in the peak years of the cycle, Merrill says.
Merrill estimates that the current bull cycle could be even more favorable. Over the next two years, inventories are projected to fall to the levels they hit during the 1988-91 bull run, but global demand is much higher than it was then.
Demand is rising, thanks to a strengthening economic recovery in the U.S. and continued rapid growth in China. In turn, a lot of that demand is coming from production of stainless steel, which uses about 60% of the worldwide nickel supply. Stainless steel production in the Western economies climbed 7% in the year's first half. Stainless production in China has been growing at 11% annually, which is still well below the massive 29% average annual growth rate for stainless consumption in China since the top of the last bull market for the metal in 1991. The gap between Chinese stainless production and consumption has fueled solid production growth in South Korea and Japan.
Limited Supply
Meanwhile, there aren't any huge new nickel mines set to come into production before Inco's Voisey's Bay and Goro projects in 2006. The first is in Labrador in eastern Canada; the latter is in New Caledonia in the South Pacific.
Using a price of $5 a pound for nickel at the peak of this cycle, which could well be conservative, I get a 12-month target price of $37 a share for Toronto-based Inco.
Inco is a relatively easy mining stock to analyze because the bulk of the company's revenue comes from a single metal and because historical bull and bear prices for nickel are clearly defined.
Freeport-McMoRan is a tougher case because the company's production is concentrated in two metals, and it's difficult to attach gold prices to booms and busts in the supply/demand cycle.
But Freeport-McMoRan is worth the trouble because copper shows an even more attractive cyclical picture than nickel, and investor psychology seems to be running in a long-term trend in favor of gold.
Headquartered in New Orleans, Freeport-McMoRan is the world's low-cost copper producer, thanks largely to the extraordinary Grasberg mine in West Papua, the Indonesian side of the island of New Guinea and its mind-boggling mix of copper and gold deposits. The mine is simultaneously the world's second-largest copper mine and the world's largest gold mine: The combination means that Freeport-McMoRan can produce copper for a cash cost of about 7 cents a pound, compared to the industry average of about 45 cents a pound. Operating margins at Freeport-McMoRan are 30% to 35%.
Low Costs, Higher Prices
Freeport's low costs mean that every penny increase in the price of copper adds about 5 cents a share to the company's earnings, according to Merrill, which forecasts copper prices of 77 cents a pound in 2003. Citigroup's Smith Barney recently raised its forecast for the price of copper to 85 cents a pound in 2004 and 90 cents a pound in 2005.
But it's the company's gold exposure that gives Freeport-McMoRan its extra juice. The shares now trade at about 19 times projected 2004 earnings per share of $1.77. That's near the midpoint of the trough-to-peak multiple range for copper mining companies, Smith Barney calculates. North American gold mining companies, on the other hand, now sell for 30 to 35 times earnings. That valuation gap implies that investors can look forward to an improving multiple for the stock as a whole from Freeport-McMoRan's gold operations. The company has 44 million ounces of proven gold reserves on its books.
I calculate a very conservative 12-month target price of $40 a share for Freeport-McMoRan. Conservative, because investors are getting a low-cost producer of gold and copper at the early stages of the bull cycle in both metals. Freeport-McMoRan also has one of the best balance sheets among mining companies.
In 2003, the company has reduced debt, redeemed high-yielding preferred shares and added a dividend on its common shares for the first time since 1998. The company is on track to finish 2003 with cash balances of better than $400 million. That's quite an improvement from the less than $10 million in cash at the end of 2002. Free cash flow is likely to exceed $200 million next year.
Some analysts on Wall Street say the hottest metal now is copper, and investors looking for a pure play in it with a lot of momentum should do their homework on the American Depositary Receipts of Southern Peru Copper.
Down South
Southern Peru Copper is positioned to take full advantage of the turn in the copper cycle. Production is climbing -- up about 17% in the second quarter over the same period in 2002. Costs are falling on higher volumes and on the company's investment in improved smelting equipment. There's been good news on that front lately with projected capital costs for the next round of smelter upgrades falling well below earlier estimates. Southern Peru Copper recently projected that income will rise to $100 million in 2003 from just $61 million in 2002.
The stock trades at a 10% to 15% discount to the rest of the copper mining group. The big question on the stock is whether that's enough to make up for the extra risk. Peru, the company's sole base of mining operations, isn't the most stable country in the world, and while the company does file regular financial statements with the Securities and Exchange Commission, it can be hard for U.S. shareholders to assess the management of a foreign company. In addition, investors in the company's ADRs are becoming the junior partners of controlling shareholder Grupo Mexico.
Investors who want to concentrate on copper but want to stay closer to home can take a look at Phoenix-based Phelps Dodge (PD:NYSE) instead. But be aware that shares of the larger company, with its $4.5 billion market cap, are likely to be far less volatile than those of smaller Southern Peru Copper, with its $1.6 billion market capitalization.
And less volatility, while generally a good thing, may not be what you want now in the early stages of a bull market cycle in mining stocks. |
